The Buffett indicator. What is it?
To put in simple terms, the Buffett indicator is the ratio of a specific country’s stock market capitalization to the country’s total GDP. If the ratio is too high, the market is likely to fall, and it’s expected to rise if it is too low. The Buffett indicator is not designed to be applied for a period of a day or week, rather, it predicts large-scale market trends based on many years of data.
The theory behind the Buffett indicator states: if the market capitalization is excessively low, it’s up to the free-floating excess capital to fill the gap, with the market going bullish as the result. On the other hand, if the stock market prices are too high when compared with GDP, the economy is not in a strong position to support ongoing and future investments, and thus the market will fall. The basic underlying assumption behind this theory states that the stock market reflects an economy’s ability to produce returns for its investors.
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Undervalued vs Overvalued
More precisely, if the stock market capitalization is anywhere above 115%, it is considered overvalued. If it’s value is 75% to 90% of the GDP, it is at the right level, and if it is below 50%, it is very low. So, if the market is overvalued according to the Buffett indicator, does that mean it will soon crash? No, it’s not and there is no need to panic. The Buffett indicator was not designed to predict a market crash, but if the market is indeed overvalued, the returns will start to even out over the years. A typical Buffett indicator graph looks at follows:
This graph is just an example and doesn’t reflect any real-world data.
How is the Buffett indicator used?
If the market is overvalued, rather than being an alarmist, it’s best to use a simple yet effective way to deal with it, namely, to apply the same indicator to find markets where stocks are undervalued. Buying these countries’ indexes can be a smart way to ensure handsome returns over the coming years and to hedge against losses. There are still many markets in South America and Asia that have undervalued stocks.
Secondly, investors have the option to take the core principles of Buffett Indicator and apply them down to specific companies and sectors. Investors might be able to find a company with higher dividends than its competition, and this firm will most likely rise in value. Similarly, if there is a sector in the economy with a market value lower than its historical value, there is a good chance that it will go up.
To sum it up
Buffett Indicator is one of the most reliable indicators in the stock market and is highly regarded in the investment world. Is Buffet Indicator valid for all markets? The answer is yes, but the basic condition is an absence of sudden events in the market. This indicator is not used to predict the sudden rise or fall of any market, but works as a tool that predicts long-term trends. This was the Buffett indicator explained!